e-YWM ALERT #4-How to Reduce your 2010 or 2011 Income

Numerous tax breaks (tax credits, deductions, and other tax benefits) are reduced or eliminated if a taxpayer's adjusted gross income (AGI), or modified AGI (MAGI), exceeds specified thresholds. As year-end nears, taxpayers whodo not anticipate being subject to higher rates next year should consider reducing their 2010 AGI by deferring taxable income into 2011, or by accelerating deductions, if doing so will keep their income level for the current tax year below the relevant phase-out thresholds (or will mitigate the effect of the phaseouts).

Not all steps listed below will be available or desirable for every individual, but many whose income without any planning would be in the range of a threshold may be able to use one or more of the following strategies to keep AGI below the applicable level:

• Convert taxable interest to tax-exempt interest.This will be especially practical where an individual will recognize little or no gain on the disposition of a taxable investment, such as when shifting funds in a taxable money market account to a tax-exempt fund. The tax-exempt interest will not be included in AGI (except in determining the taxability of Social Security benefits), and for some individuals, the after-tax amount received from tax-exempt interest will be at least as much as the after-tax amount received from taxable interest. That's especially true if the tax-exempt interest is exempt from state or local income taxes as well as from Federal income tax.

Caution:Taxpayers who might be subject to the alternative minimum tax should usually avoid investing in tax exempt private activity bonds since the interest on those is included in determining alternative minimum taxable income even though it's not included in AGI.

• Convert taxable interest to tax-deferred interest or income.Instead of leaving funds in a savings or money market account generating taxable interest, some individuals may want to shift some funds to U.S. Series EE bonds or inflation-indexed U.S. Series I savings bonds. Unless the individual elects otherwise, "interest" on Series EE or I bonds isn't taxed until the bonds mature or are redeemed. Another possibility would be to buy Treasury Bills with a term of one-year or less that mature in 2011 so that the income from the Bills won't be included in gross income until that year. Alternatively, individuals may shift funds from investments that produce currently taxable income to beaten-down growth stocks, which pay little or no dividends and give the individual the ability to control when any gain on the stocks will eventually be realized by timing their sale to suit his tax goals.

• Pay off debts.If an individual has both income-generating investments and debts on which he is paying interest, he should consider selling part of his investments and using the proceeds to pay off debt. In addition to reducing AGI, this may increase the individual's net income because the reduction in interest payments often is greater than the reduction in the income received on the investment.

Recommendation:If an individual in this situation is reluctant to repay current debt for fear that he may need the capital in the near future, then, if eligible, he should consider taking out a home equity credit line to draw on in case of need instead of keeping both income earning investments and debt.

•Increase contributions to retirement plans.Some individuals may be able to reduce AGI by increasing contributions to retirement plans such as 401(k) plans, SIMPLE pension plans, and Keogh plans.

Illustration : Sharon has compensation income above $100,000 and usually makes elective deferrals of $5,000 a year to the 401(k) plan maintained by her employer. For 2010, Sharon doubles her elective deferral amount to $10,000, effectively making her 2010 and 2011 contributions in 2010. This will reduce her 2010 AGI by $5,000 more than her normal 401(k) contribution would.

Caution:Assume an employer makes matching contributions to a 401(k) plan at one rate for elective deferrals up to a certain percentage of compensation and at a lower rate for elective deferrals of greater percentages of compensation (as frequently is the case to induce non-highly compensated employees to participate). The strategy described above will cause the employee to lose some employer matching contributions, unless the employee also makes his usual contribution for 2011 in addition to doubling up for 2010.

• Increase contributions to Health savings account (HSA).Individuals who are covered by a qualifying high deductible health plan (and are generally not covered by any other health plan that is not a qualifying high deductible health plan) may make deductible contributions to an HSA, subject to certain limits. For calendar year 2010, assuming a full year of coverage, the maximum contribution for self-only coverage is $3,050, and for family coverage it's $6,150. In addition, an individual who has reached age 55 before the close of 2010, can make a catch-up contribution of $1,000. Distributions from an HSA to pay qualified medical expenses are not taxable. Distributions used for nonmedical purposes are taxable, and if made before age 65, are subject to a 10% penalty tax. An individual's HSA contribution level may be based on expected out-of-pocket medical expenses, but there is nothing to prevent an individual from making deductible contributions up to the maximum allowable amount, regardless of expected expenses. These contributions in excess of medical needs can be withdrawn from the HSA and used for any purpose without penalty (but subject to tax) once the individual reaches age 65.

• Defer receipt of year-end bonuses.An employee who believes a bonus may be coming his way may request that his or her employer delay payment of any bonus until early in the following year. For example, if a bonus would normally be paid on Dec. 15, 2010, an employee may ask the employer before Dec. 15 to defer any bonus coming his way until January 2, 2011. By deferring the bonus, the employee will avoid having it included in 2010 income.

Caution:If an employee waits until a bonus is due and payable to request a deferral, the doctrine of constructive receipt will be triggered and the inclusion of the bonus in AGI will not be deferred. Also, if the deferral extends beyond two-and-one-half months after the close of the tax year, the bonus will be treated as nonqualified deferred compensation. Bonuses treated as deferred compensation are currently includible in income to the extent not subject to a "substantial risk of forfeiture" if the arrangement fails to meet certain distribution, acceleration of benefit, and election requirements. The impact of the 6.2% Social Security portion of the FICA tax may also affect the timing of a bonus. For example, if an employee is retiring in 2011, the employee's salary alone may exceed the Social Security wage base in 2010 ($106,800) but not in 2011. As a result, postponing a bonus payment from 2010 to 2011 could convert a bonus exempt from the 6.2% Social Security tax into a bonus subject to that tax.

• Pay up to $2,500 of student loan interest.Up to $2,500 of student loan interest paid during a tax year is deductible in computing AGI. A taxpayer should consider deducting up to this amount in a tax year even if less than that amount is required to be paid in that tax year.

Observation:The deduction for payments of interest on a student loan applies to voluntary interest payments such as payments made on a qualified student loan during a period when interest payments aren't required, because, for example, the loan hasn't yet entered repayment status or is in a period of deferment or forbearance. Thus, such voluntary payments will reduce AGI to the extent the total amount paid in any tax year does not exceed $2,500.

Observation:Under EGTRRA sunset rules, after 2010 (unless Congress acts) the above-the-line student loan interest deduction under Code Sec. 221 (1) phases out over lower modified AGI ranges and (2) applies only to interest paid during the first 60 months in which interest payments are required. The possibility of more stringent rules next year makes accelerating student loan interest deductions into this year more worthwhile.

• Pay back alimony in 2010.An individual required to pay alimony to a former spouse is entitled to deduct that alimony in the year paid. Accordingly, to the extent possible, such an individual should consider deducting any alimony owed for prior years in 2010, since the full amount paid in 2010 will be a deduction from AGI.

• Pay moving expenses in 2010 even if move isn't made until 2011.Residential moving expenses are deductible (including from AGI) by the taxpayer in the year paid or incurred. Thus, where a taxpayer paid professional movers in December of 2010 1, but the actual move wasn't made until January of 2011, the taxpayer is entitled to the deduction on his 2010 return.

Illustration: In 2010, taxpayer changed job locations, causing her to incur deductible moving expenses. Among these were the expenses of moving furniture, which she paid in 2010, and expenses of travel to the new job location, which she paid in Year 2011. Taxpayer may deduct the furniture-moving expenses in 2010, and the travel expenses in 2011.

All information presented above is generic, if you would like to know how this may be applied to your specific situation please give us a call at 303-792-3020. Additional resources are always available at our website, www.ywmcpa.com.